Emerging Markets

Finding the Reward Amid the Risk in Bonds

Investors have increasingly eschewed dollar-denominated emerging-market bonds in favor of those sold in a country's local currency. The yields are slightly higher, but probably not worth the many and varied risks involved.

This year has been a different story. Dollar-denominated emerging-market bonds have dropped 3.1% so far in 2013, and investors pulled $300 million from the asset class in the first week of February alone.

Investors may be heeding what the pros have been saying (in the pages of Barron's and elsewhere)—that there was little room left to grow in dollar-denominated bonds, and that they were finding more opportunities in local-currency bonds. Funds dedicated to the local-currency bonds have been the recipients of $8.1 billion in the first seven weeks of this year, nearly half of what was put into the asset class in all of 2012.

Investors may be taking more risk than they realize, however. These bonds are not simply a yield or credit play, but add foreign-exchange risk to the equation. In the best of times, currency fluctuations can mean the difference between making and losing money. But with talk of currency wars and Federal Reserve exit strategies, this may be an especially risky time to take on currency risk.

To be sure, the impulse to switch out of emerging-market dollar bonds hasn't been a bad one. Because these bonds are denominated in the U.S. dollar, they tend to track U.S. Treasuries. Since Dec. 6, the 10-year Treasury yield has jumped to 2.01%, from 1.59%—meaning prices have fallen—and emerging-market dollar-bond prices have dropped as well.

Even with the recent price drop, dollar-bonds aren't the value they were even just a few months ago, says Alain Bokobza, head of strategy at Société Générale. Back in September, an investor could pick up an extra five percentage points by buying EM dollar bonds. These days, the difference is just 3.5 percentage points, near the three-point difference that has been typical during periods when the market (as reflected in the CBOE Market Volatility Index, known as the VIX) appears worry-free, Bokobza says.

It's not entirely clear that EM bonds denominated in local currencies are the answer for investors reaching for yield. For starters, this is a tough environment for picking currencies. The debate about the so-called currency war—in which nations try to devalue their currencies to gain a trade advantage—rages on.

Real or not, investors ignore it at their own risk. That's because some developing countries will respond with devaluations of their own, while others will accept stronger currencies. That, says Eric Fine, manager of the
Van Eck Unconstrained Emerging Market Bond
Fund (EMBAX), might be the key to making—or losing—money.

And when currencies drop, bond returns drop with them. For instance, the dollar gained 18% versus Brazil's real during the three months ended May 31, 2012; Brazil's local-currency bonds fell 10% in that period.

And local bonds are not exactly cheap right now. While investors get a larger-than-average yield versus Treasuries, absolute yields are dangerously low, says Hans Olsen, head of investment strategy, Americas, at Barclays' Wealth and Investment Management. During the past 10 years, the yield has been higher than it is now 95% of the time, he says. "You're playing for small dollars at this point," Olsen says.

And that's before looking at their benchmark interest rates relative to inflation, says Themistoklis Fiotakis, a strategist at Goldman Sachs in London. Turkey, South Africa, and Hungary, for instance, all have negative real rates, while Brazil's rates relative to inflation have dropped three percentage points in the past year. "The key question is how appropriate such low levels are for these countries," he says.

But even those who are cautious on local-currency debt say investors shouldn't give up on the asset class entirely. "There are still pockets of value," Barclays' Olsen says. "You shouldn't throw the baby out with the bathwater."

It does mean investors should look to actively managed funds—especially those that can invest across the entire range of emerging-market debt, and have a history of managing the volatility. The
TCW Emerging Markets Income
Fund (TGEIX), for instance, returned 17% during the past 12 months, near the top of its category, while having price swings of 3.7% during the past year of trading. The
Payden Emerging Markets Bond
Fund (PYEMX) has returned 14% during the past 12 months, with historical volatility of 4% during the past year.